Chapter 11

Derivatives
markets

©2019 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

11.1 explain the characteristics of forwards and futures
11.2 explain how financial-market participants use futures
11.3 discuss the risks involved in using financial futures
contracts to hedge an underlying risk exposure
11.4 explain the characteristics and uses of options
11.5 discuss the regulation of the futures and options
markets
11.6 explain how swaps work and how they can be used to
reduce interest rate risk.
 The nature of forward and future markets

• A derivative security is a financial instrument whose value

is derived from some underlying security.
• Derivatives contracts include:
‒ Forwards
‒ Futures
‒ Options
‒ Swaps
 The nature of forward and future markets

• Forward markets:
‒ A forward contract guarantees the delivery of an amount of
goods on a specific day in the future.
‒ A forward contract involves two parties agreeing today on a price
(the forward price) at which the purchases will buy a specific
amount of an asset from the seller on a fixed future date.
‒ The forward contract differs from a spot market transaction
where buyer and seller conduct their transaction for immediate
delivery at the spot price.
 The nature of forward and future markets

• Forward markets cont’d:

‒ Spot price is the observed price at which current
transactions take place.
‒ The buyer of the forward contract is said to have a long
position. The seller is said to have a short position.
‒ The forward price for an asset is that price that makes
the forward contract have a zero net present value.
 The nature of forward and future markets

• Futures markets:
‒ Futures contracts differ from forward contracts.
‒ These differences are summarised as follows:
• Futures trade on an organised exchange
• Futures contracts are standardised
• Parties to a futures contract hold contracts with the
exchange or clearinghouse and not with each other.
• Futures positions are marked to the market each
day (profits and losses are settled each day).
 The nature of forward and future markets

• Futures markets cont’d:

‒ Futures exchange is a place in which buyers and sellers
can exchange futures contracts.
‒ The exchange keeps the books for buyers and sellers
when contracts are initiated or liquidated.
‒ In futures markets, a requirement that gains or losses
on futures positions be taken into account in
determining the value of all contracts each day.
 The nature of forward and future markets

• Futures markets cont’d:

‒ To minimise the risk of default of one or both of the
parties, the clearinghouse requires the posting of
margin.
‒ The margin is a deposit, which ensures the completion
of the contract.
‒ The clearinghouse manages the margin requirements
continuously.
‒ If a trader experiences a loss, they may be required to
post additional margin in their account.
 The nature of forward and future markets

• Futures markets cont’d:

‒ Futures-market participants
• There are two major types of participants in futures
and forward markets:
‒ Hedgers: Individuals or firms that engage in
financial-market transactions to reduce price risk.
‒ Speculators: Those who assume price risk in the
expectation of earning a high return.
 Uses of the financial futures markets

• Risk management:
‒ Futures can be used to manage the risks associated
with changing interest rates and asset prices.
‒ Futures prices move inversely with interest rates and
directly with asset prices.
‒ The sale of futures, therefore, can offset price risk.
 Risks in the futures markets

• There are substantial risks in futures markets. An

important risk to be aware of is basis risk.
• Basis risk is the risk that derives from the failure of the
spot price to always keep the same price relationship with
contracts purchased or sold in the futures markets.
• For example, it is possible that a fall in the share market
may be greater than the fall in the futures market. The
gains from the futures will not offset the losses on the
shares.
 Options markets

• Futures can, at least in theory, completely insulate a firm

against price changes.
• This has a drawback: hedging with futures can reduce the
firm’s losses if prices move adversely but they also
eliminate gains if prices move favourably.
• Because of this, some people prefer to use options for
hedging instead of futures.
 Options markets

• Trading options in Australia:

‒ Options are traded on the ASX and SFE (which is now a
part of the ASX).
‒ The ASX trades options on share indices and many
individual shares.
‒ The SFE trades options on many of the futures
contracts listed there.
 Options markets

• Nature of options:
‒ An option gives the holder the right but not the
obligation to buy or sell an asset at a predetermined
price.
‒ The price is called the exercise or strike price.
‒ The option buyer pays the option seller a price (called
the option premium) for the right.
 Options markets

• Calls and puts:

‒ The two types of options are called calls and puts.
‒ Calls give the holder the right to buy the underlying
asset.
‒ Puts give the holder the right to sell the underlying
asset.
‒ Options are created by individuals who sell (write)
them.
 Options markets

• Option prices:
‒ The price of an option (the premium) depends on a
number of factors:
• The price variance of the underlying asset
• The changes in the price of the underlying asset
relative to the option’s exercise price
• The dividends of the underlying share
• The time left until the option expires
• Interest rates
 Options markets

• The value of an option:

‒ The value of an option changes over time.
‒ Just before expiry, the value of a call option is equal to
its intrinsic value (the value if exercised immediately).
‒ The call’s intrinsic value is equal to the greater of the
value of the underlying asset minus the exercise price
or zero.
‒ Before expiry, the option will have additional value
called time value.
 Swap markets

• Swaps are a relatively new form of financial transaction

that have emerged over the last 25 years or so.
• Swaps involve the exchange of payment obligations on
two underlying financial liabilities where principal
amounts are the same but the payment patterns are
different.
 Swap markets

• Notional principal:
‒ A swap only involves a net transfer of funds.
‒ That is, if one party to a swap owes the other 6% on a
notional principal of $1 million and the second party
owes the first party 5%, the first party only pays the
second $10 000 per year.
‒ The $1 million principal never changes hands.
 Swap markets

• Why swap?
‒ There are two main reasons for entering a swap:
• To hedge interest rate risk by exchanging fixed rate
payments for floating rate payments; and
• To take advantage of credit risk differentials.
 Swap markets

• Swap dealers:
‒ Because the obligations of various counterparties are
not perfectly matched, swap dealers serve as
counterparties to both sides of the swap.
‒ Dealers operate a ‘book’ of swaps, which they try to
keep as closely matched as possible so as to minimise
market risk.
 Swap markets

• Regulation of swap markets:

‒ Swap markets are less regulated than other markets.
‒ There is no central clearinghouse for swaps but APRA
does play a regulatory role.
‒ Whilst defaults on swaps are low, banks are required
to apply risk-adjusted capital requirements to swap
risks.